Published:
October 12, 2013

WHEN a company receives
criticism about its
executive pay practices, a typical defense is to cite a rising stock
price as justification of its pay. If total shareholder return is up,
the theory goes, stockholders have no right to complain about what might
otherwise look like outsize pay at their companies.

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While this pay posture
is understandable, it raises a question: Should a rising stock price
inoculate top executives from criticism over their pay? To more and
more experts in corporate finance and pay issues, the answer is no.

Aswath Damodaran, a professor of finance at the Stern School of
Business at New York University, is among those who think that too
many companies rely too heavily on the performance of their shares
when computing executive compensation. “I’m a great believer in
markets, but sometimes we need more attention paid to what did this
management do to the value of the company and less to what did this
management do to the price of the stock,” he said. “I would like to
see compensation systems where managers are rewarded based on what
kind of projects they are working on and how big their returns on
invested capital are.”

And yet, the focus on
stock price appreciation as a benchmark for corporate performance
and executive pay lives on. Companies still rely heavily on it and
so do the powerful proxy advisory services that suggest how
shareholders should vote on pay practices and director elections.
The fact is, total shareholder returns are almost always among the
performance measures — if not the single biggest consideration —
used by companies to determine pay.

This focus doesn’t just
leave out a wide array of measures that better capture whether a
company’s management is operating in the interests of investors with
a long-term horizon. It also allows top executives to reap the pay
benefits associated with a short-term bullish stock market, which
may have nothing to do with their company’s specific business or
operations, pay experts contend.

“A statistic I’ve seen
that makes sense to me is that 70 percent of executives’ stock
option gains are attributable to the market’s movement as a whole,”
said Nell Minow, a principal at
GMI Ratings, a corporate governance analytics company. “We are
basically paying C.E.O.’s for floating on their backs when we should
be paying them to win races.”

The fault is not simply
with executives themselves, of course. A failure to weigh a variety
of performance metrics that can warn when a company isn’t creating
long-term shareholder value is the responsibility of the company’s
board.

Shareholders, too, have
to hold themselves accountable for these failures, Ms. Minow said.
Their support for pay plans that reward executives for just showing
up or for being on hand while their stock is rising only reinforces
a questionable reward system.

“This is something
where we have to blame ourselves,” she said.

With that in mind, Mark
Van Clieaf, an organizational consultant and principal at
Organizational Capital Partners, is urging companies’ boards to
use other measures to assess whether their executives are truly
creating value for shareholders or destroying it. The best measure,
he says, is a company’s net returns on its invested capital. That
is, how much it is generating on its capital investments — plants
and equipment, say — minus the costs of that capital, whether debt
or equity.

“Management should be
providing value that exceeds its cost of capital,” Mr. Van Clieaf
said. “A company with a negative return on capital can’t generate
enough free cash flow to pay dividends and enhance the value of the
firm over time.”

In spite of this
relatively simple concept, Mr. Van Clieaf said, few companies appear
to use net returns on invested capital, also known as economic
profit or loss, when determining executive pay. This is something of
a disconnect, given that these returns are a crucial measure of how
effectively a company is deploying its capital into projects that
pay off, and are certainly figures that chief executives and their
finance colleagues watch closely. Moreover, returns on capital are a
useful measure across industries.

Neither do shareholders
seem to be demanding such a measure when their companies’ boards
devise executive pay. “Investors are looking at total shareholder
return, but that’s not the be-all, end-all metric,” Mr. Van Clieaf
said. “So just because a company had a positive say-on-pay vote
doesn’t mean the system is working well.”

The trouble with
relying on total shareholder returns is that these figures can rise
even after a company has shown an economic loss — a negative return
on capital — over an extended period. A focus on stock price,
therefore, can mask a longer-term decline in a company’s financial
footing.

AN extreme example of a
company that had returns on invested capital that were below its
cost of capital is WorldCom, the telecommunications darling that
collapsed in 2002. According to
“Foundations of Economic Value Added,” a book by James L. Grant,
from 1993 to 2000 return on invested capital at WorldCom ranged from
2.23 percent to a high of 9.5 percent, but the company’s cost of
capital was more than 10 percent throughout this time. For much of
that time period, WorldCom’s stock price was rising.

WorldCom, of course,
was in a category by itself. But the message is clear: a stock price
does not always reflect real economic value. Mr. Van Clieaf labels
these kinds of companies “value myths” because on the surface they
are producing gains for shareholders but underneath they are
generating negative returns on their investments in plants,
equipment, acquisitions or other items.

To illustrate this
point, Organizational Capital Partners generated a list of eight
large companies that for each of the five years through December
2012 generated a negative net return on invested capital. The firm
also looked at other metrics, like revenue growth or decline, total
shareholder returns and cumulative executive pay over the period.

The analysis also
includes the results of the latest shareholder votes on each
company’s pay practices. These so-called say-on-pay votes are not
binding on the company but represent shareholders’ views on the pay
programs that are in place. Most of the companies received broad
support for their pay practices from most of the shareholders voting
at the most recent annual meetings. Only three of the eight —
ConocoPhillips, Dow Chemical and Tenet Healthcare — encountered
objections from more than one-quarter of their shareholders voting
on the executive pay plans.

The list of eight
companies that generated a negative net return on invested capital,
ranked by the amount of executive pay, is above. Most of the
companies are in basic industries like energy, chemicals and
industrial products. Five of the companies had shareholder returns
that beat the Standard & Poor’s 500’s returns over the five-year
period. These were, in descending order, Tenet, Dow Chemical,
Anadarko Petroleum, Johnson Controls and ConocoPhillips.

The remaining three
companies — Apache, Devon Energy and Textron — had negative
shareholder returns for the period.

I shared the
Organizational Capital Partners findings with all eight companies.
Some, like ConocoPhillips, Dow Chemical and Tenet Healthcare, did
not respond to e-mail requests. Others, like Devon Energy, Anadarko
Petroleum, Johnson Controls and Textron, declined to comment,
referring me to proxy filings that outline their compensation
practices.

At Apache, the board is
focused on getting pay for performance right and has been engaging
its shareholders, said Sarah B. Teslik, its senior vice president
for policy and governance. Investors like how much of the company’s
executive compensation is tied to measurable corporate goals, she
said, and the fact that the company has substantially reduced the
pay that Apache executives actually realize, meaning it is not
earned if the performance goals are not met.

Bob Dye, Apache’s
spokesman, added that the company’s share price had been hurt in
recent years by investor concern over its large operations in Egypt.

Given the shareholder
support that most of these companies received in their most recent
say-on-pay votes, it is clear that investors seem content with their
pay practices. To Mr. Van Clieaf, this is a sign that investors are
not digging sufficiently into the numbers to determine whether
companies are creating long-term shareholder value.

Monitoring these
returns is important work for investors, he said, because companies
that do not earn positive returns on their invested capital may not
be able to pay dividends to shareholders. And those dividends make
up one of the bigger income streams that pension managers look for
to meet their obligations to retirees.

HOW did some of the
larger private money managers vote on these companies’ pay practices
at their most recent annual meetings?

The proxy record of
Fidelity Investments, Vanguard and T. Rowe Price on many of these
companies shows broad support for management. For example,
Fidelity’s Large Cap Stock Fund voted in support of Johnson
Controls’ pay practices and the Fidelity Energy Central Fund
supported Anadarko Petroleum’s executive pay program.

T. Rowe Price, another
large
mutual fund company, did not vote in lockstep with management,
however. At the most recent meeting of Apache shareholders, for
example, its New Era Fund voted against the company’s pay plan.

Finally, Vanguard’s
votes by its huge S.& P. 500 index fund, which must own all those
shares that are in the index, were supportive of all eight
companies’ pay for performance plans.

Spokesmen for all three
fund companies said they would not discuss how their funds voted on
specific companies. Vincent Loporchio, a spokesman for Fidelity,
says it generally votes to ratify companies’ pay practices unless
the compensation seems unaligned with shareholder interests. When a
company’s proposal doesn’t conform to the proxy voting guidelines,
Fidelity may contact the company to discuss the situation and
potential solutions, he said. It might vote in favor of a proposal
if management commits to changes in governance and compensation
practices, Mr. Loporchio said.

Fidelity voted against
24 percent of all equity plan proposals for the year ending June 30,
2013, he said.

At T. Rowe Price, votes
on pay practices are made on a case-by-case basis, using a
proprietary and quantitative scorecard initially, a spokesman, Bill
Benintende, said. “We vote ‘against’ in cases where there is an
unacceptable number of problematic pay elements,” he said, including
poor linkage over time between executive pay and the company’s
performance and profitability, or objectionable features like
excessive retirement plans, golden parachutes or perquisites.

Glenn Booraem,
principal and fund controller at Vanguard, said the fund company
recognized that assessing pay based solely on total shareholder
return was inadequate. “One of the places where we are more
concerned than others is where the entirety of comp is tied to
absolute stock price performance of the particular company,” he
said. Each year, Vanguard has discussions with around 500 companies
out of the 4,000 or so in its portfolios to discuss governance or
compensation problems the fund company has identified. Many of these
discussions result in changes that do not require voting against a
particular pay package or other shareholder proposal, Mr. Booraem
said.

Still, Ms. Minow says
these and other investors have a great lever on pay that they are
not using. “Investors are just now beginning to vote against
companies’ pay plans,” she said. But voting against pay was not
enough.

“You have got to tie
together a vote against a pay plan with a vote against the
compensation committee of the board,” she said. “Unless we focus on
the comp committees, nothing is going to change.”

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A
version of this article appears in print on October 13, 2013,
on page BU1
of the New York edition
with the headline: When the Stock Price Hides Trouble.

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